Tuesday, June 9, 2015

Greek finance minister Yanis Varoufakis recently penned a Project Syndicate essay in which he challenged German Chancellor Angela Merkel to give a "Speech of Hope" in Greece in the manner of US Secretary of State James Byrnes did in 1946. In that speech, Byrnes' speech signaled an about face in American foreign policy towards Germany by reversing its intention to de-industrialize the conquered and shattered nation:

Byrnes’ speech signaled to the German people a reversal of that punitive de-industrialization drive. Of course, Germany owes its post-war recovery and wealth to its people and their hard work, innovation, and devotion to a united, democratic Europe. But Germans could not have staged their magnificent post-war renaissance without the support signified by the “Speech of Hope.”

Prior to Byrnes’ speech, and for a while afterwards, America’s allies were not keen to restore hope to the defeated Germans. But once President Harry Truman’s administration decided to rehabilitate Germany, there was no turning back. Its rebirth was underway, facilitated by the Marshall Plan, the US-sponsored 1953 debt write-down, and by the infusion of migrant labor from Italy, Yugoslavia, and Greece.

Varoufakis went on to challenge Merkel to deliver a similar "Speech of Hope" and presumably echo the same kinds of policies that America did with Germany in 1946. Varoufakis seems to be very good at evoking the kinds hope that Greece can embark on a growth path to prosperity:

Europe could not have united in peace and democracy without that sea change. Someone had to put aside moralistic objections and look dispassionately at a country locked in a set of circumstances that would only reproduce discord and fragmentation across the continent. The US, having emerged from the war as the only creditor country, did precisely that.

Suppose we were to fantasize for a moment and imagined that Varoufakis got everything he wanted, namely some form of debt relief and a stimulative Marshall Plan. What would happen to Greece under such circumstances?

The Competitive Advantage of Nations
To answer that question, I would use a development economics framework by following the work of Michael Porter, who wrote The Competitive Advantage of Nations, and Jane Jacobs, whose works included The Economy of Cities and Cities and the Wealth of Nations. The ideas of Porter and Jacobs are quite similar. One of Porter's formulas for success is the existence and development of industry clusters, e.g. Silicon Valley, which becomes a hub that spawns industry excellence, development and employment. Jacobs' work more or less says the same thing, except that her unit of development is the city-state instead of Porter`s focus on country-specific development.

Now consider the cases of post-war Germany and Greece today. Even though it was shattered by war, 1946 Germany was endowed with a considerable amount of human capital. The Germans had a tradition of excellence in science and engineering that went back years. As an example, German companies had a technological lead in chemicals in the late 19th and early 20th Century. Today, companies like Bayer and BASF carry on that tradition of German chemistry. The Second World War was marked by German "wonder weapons". It was therefore not a surprise that there was a scramble for former German rocket scientists after the war.

What competitive advantages does Greece have today?

A glance at the chart of GDP per capita (via Ian Bremmer) shows that Greece is one of the poorest regions in the eurozone, with the "rich" eurozone regions being Germany, northern Italy, northern Spain, the Low Countries and Ireland.

Supposing that Greece were to get some form of debt relief and growth stimulus, how could it lever its competitive advantages and get on a growth path?

The Telegraph recently featured a photo essay of the derelict factories of Greece. Perhaps we can see what industries Greece had before its economy cratered. While the photo essay may not entirely be representative of Greek industry, it does give us some idea of what was there. The photos included abandoned plants specializing in:

Textiles

Building supplies (marble, insulation)

Food processing (cooking oil, grains, dry nuts)

None of these are high value-added industries. In particular, textiles manufacturing has been un-competitive in developed countries for years as most of the production has gone to emerging market economies.

With the exception of tourism and limited food processing, Greek industry has few competitive advantages to lever to return to a superior growth path.

There is one other possible competitive advantage that Greece possesses in the form of its geographical location. Various people have suggested that Athens could play the Russian card and perhaps move into Moscow`s orbit. Such a development would be an enormous blow to the EU and NATO. The accusations of "Who lost Greece" would begin. However, I would tend to discount that possibility. Russia had the opportunity to insert itself into the Mediterranean during the Cypriot crisis in 2012 at a far lower cost but declined (see Europe dodges another bullet (not the Catalan election)). Given Russia`s somewhat shaky finances, it is difficult to see how Putin could rescue Greece in a meaningful fashion.

Micro vs. macro solutions

This is the story of a Greek tragedy. Greek tragedies are marked by the clash of good vs. good, where different parties approach a situation with good intentions but end in tragedy.

It is also the story of two parties talking at each other instead of with each other. The Greek approach, which is top-down and macro oriented, rests with the idea that somehow the country can return to sustainable growth if the macro problem of excessive debt were to be lifted (and hopefully coupled with some form of stimulus plan).

By contrast, the (mostly) German plan is highly bottom-up and micro-economic oriented. Its underlying philosophy calls for getting the right market mechanisms in place, e.g. cost structures, labor market reforms, the right incentives, etc., and growth will naturally follow. The problem with this approach is that Greece, unlike countries like Ireland, has few competitive advantages. The EU mandated solution amounts to forced internal devaluation. It would mean that, in the example of textiles, that Greek wages would have to fall even further to levels that competes with the likes of China, Vietnam or Thailand.

Putting it another way, if Greece was a troubled company, Tsipras and Varoufakis believe that it has an over-levered capital structure and could be fixed with an equity injection. Merkel et al believe that it is poor operation and therefore needs to be remedied with better management and business rationalizations. They are both right and both wrong. It is both.

That`s why it`s a tragedy. The problems of Greece are very difficult and possibly intractable. The solution is well beyond my pay grade.

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Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

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